We expect the Fed to raise interest rates in September. GDP is growing above trend and we are seeing further improvement in the employment situation. In our view, the Fed will maintain a 25bp target range for the Fed funds rate, which implies that the first move will shift the target range to 25-50bp, ending at 50bp-75bp at the end of 2015 and 150bp-175bp at the end of 2016. All together this means one rate hike every other meeting in 2015 and 2016. The slow pace of rate hikes takes into consideration the somewhat tighter financial conditions, resulting from the strong dollar, given that the Fed is far ahead of other central banks. In line with this view our EUR/USD forecast for the end of 2015 remains 1.00.
Fed policymakers are giving signals that they are getting ready to hike rates this year. The US economy looks strong enough to handle a rate hike. In this note we address how the Fed is preparing for the rate hike, the path for interest rate normalisation and the instruments that the Fed could use in this process.
Economy ready for a rate hike
This time around, the economy may not be as resilient but the fundamental factors underlying US economic activity are solid and, in time, should lead to a pick-up in the pace of economic activity and inflation. Recently Fed policymakers have mentioned that the economy would need to show “some” improvement before a rate hike. Since then statements from Fed officials suggest that the economy is moving in the right direction. For instance, Dennis Lockhart, President of the Federal Reserve Bank of Atlanta said in an interview with the Wall Street Journal that a Fed rate hike is ‘close’, noting that he is open for a September move. Meanwhile, the President of the Fed St. Louis, James Bullard (voting in 2016) told the WSJ late in July that “we are in good shape” for a rate hike in September. In this same line, President John Williams of the Federal Reserve Bank of San Francisco also reiterated his forecast for a rate liftoff this year.
GDP growth, lower but above trend
Long trend GDP growth has slipped somewhat since the global financial crisis. Indeed, average trend growth was around 3.1%, but the global financial crisis took its toll with a loss in output and potential growth now around 2%. This suggests that although US economic growth is lower than in previous cycles, it is currently growing at above-trend rates. As a result, slack is diminishing and this is likely one of the major reasons the Fed will hike.
Labour market conditions firm, wages subdued
Unemployment has declined significantly during the recovery. Moreover, job openings and quits have been steadily improving in the past year. However, wage growth remains subdued. We think that slower productivity growth could be keeping wages supressed, since higher wages in a context of lower productivity reduce profit margins. However, this should not be an impediment to a rate hike. Fed Chair Yellen has repeatedly stated that higher wage growth is not a necessary condition for a rate hike.
In time, inflation should move towards the target
Inflation may look distant from the Fed’s 2% goal, but this is a medium-term objective. We expect that inflation will remain below 1% this year, but will move towards the 2% target next year. The strong economy should see slack dissipate, which should push up inflation. In addition, rising rent prices and the reduced pass-through from the stronger dollar should also lead to price increases in the coming months. Fed officials have persistently signalled that they expect some of the factors that are exerting pressure on prices to wane.
The Fed’s path for monetary tightening
In September 2014, the FOMC published “Policy Normalisation Principles and Plans”. This document provides a broad outline of how the FOMC intends to normalise monetary policy following almost ten years of extreme accommodation, which included unconventional monetary policy instruments. The Principles indicate that the Fed will continue to use a 25bp target range for the federal funds rate.
Plotting the Fed’s exit
Fed officials publish their own outlook for the feds fund rate, the so called “dot plot”. The Fed has forecasted that in 2015, the midpoint of the target range will be 62.5bp, increasing to 162.5bp in 2016. This is in line with a target range of 0.5% and 0.75% and 1.5% – 1.75%, respectively. These forecasts have been adjusted downward in the past few FOMC meetings in line with downward adjustments in GDP and inflation.
Interest on excess reserves and policy rate
It is likely that the Fed will use the Interest on Excess Reserves (IOER) to influence the federal funds rate. Indeed, we think that this deposit rate will be the most important instrument to raise key rates. This rate will correspond to the upper limit of the target range.
The IOER has been significantly above the federal funds rate since 2009. Government Sponsored Entities, including the mortgage financial entities, are not allowed to deposit at the Fed and have been willing to lend their excess funds at a lower rate than the IOER. As banks benefit from this arbitrage by borrowing from the GSE and depositing in the Fed, they are likely to compete for the funds of agencies until the effective rate has risen close to the deposit rate.
The Fed already seems to be preparing for the use of this tool. This past June, the Fed announced that the IOER payments will be based on the daily IEOR rate, rather than the average rate over a full two-week reserve maintenance period. We think the intention is to increase the effectiveness of changes in the IEOR in moving the federal funds rate. On top of this, the Fed will likely use other tools like the RRP and the TDF to drain reserves more quickly. The draining of reserves will lead to a convergence of the federal funds rate and the IOER.
We expect snail-paced rate hikes
The effectiveness of monetary policy largely depends on the prevailing financial conditions during and after the lift-off. Financial conditions are determined by movements in market variables that are important for growth and inflation, including market rates, credit spreads, equity prices and the exchange rate. Given the tighter financial conditions, the Fed is signalling a more gradual pace of rate hikes than we are accustomed to.
Indeed, the average rate hike in past cycles was 355bp and this time the FOMC has forecasted around 300bp, suggesting that the Fed will likely opt for a more gradual pace.
We see that financial conditions have been tightening since mid-2014. We think that financial conditions could tighten a bit more with the Fed leading the rate hike cycle. The ECB and the BoJ are still in an easing mode. This will result in an even stronger dollar.
Investors slowly moving towards Fed’s forecast
At the forefront of this rate tightening cycle, investors have been sceptical about the Fed hiking rates in the short term, mainly given the uncertainty around the global economy. At the same time, Fed officials have become a bit more cautious in their forecasts in the past few meetings. However, the gradual improvement in economic data has led investors to shift their expectations to a December rate hike. But this move has further to go. A hike in the Fed’s target range is fully priced in for December, but only a few are placed in September according to futures markets.
Our interest rate forecasts
We see an economy that is growing above trend. While the labour market remains solid. We expect “some” further improvement ahead as the gains in the job market continue to support the economy. This is what the Fed wants to see before a rate hike. Consequently, a rate hike in September remains our view. Tighter financial conditions will, however, lead the Fed to opt for a significantly slower pace of rate hikes than we had initially expected. We maintain our view that the federal funds rate will rise to 0.5% – 0.75% at year-end 2015. This is in line with the Fed’s midpoint target and implies two rate hikes this year, one in September and December. For 2016, we have lowered our policy rate forecast range to 1.5% – 1.75% from 2% – 2.25%. This adjustment coincides with the Fed’s midpoint forecast for 2016 and implies a rate hike every other meeting next year. In line with this view our EUR/USD forecast for the end of 2015 is 1.00.
Risks to our forecasts
Nonetheless, there are downside risks to our interest rate forecasts, particularly surrounding international developments . Negotiations between Greece and its creditors are still uncertain. Chinese GDP growth looks to have slowed and authorities are doing their best to maintain it on track. The recent yuan move has raised speculation that the Fed will now delay raising interest rates has weighed on the dollar. The US economy should be able to withstand these policy changes. Should global conditions further deteriorate, however, the Fed will act accordingly.